A Butterfly for Christmas

Well, it is the silly season and that’s one of the “silly” things about options. When you get news like the proposed merger between Qantas and British Airways, their options tend to get expensive. In circumstances like this, traders look for ways to sell this increased volatility without exposing themselves to undue risk.

A good way of achieving this is to use the short term, slightly out of the money Butterfly trade. These trades have a narrow profit zone, but they also have a very good risk to reward ratio and can normally be placed quite cheaply. The idea is let the share trade up into that zone coming into expiration

QAN has been in an Elliott Wave 4 Down pattern for sometime and has started to turn back up into a Wave 5 Buy type trade, crossing the EBOT on the 24th November. The Oscillator, whilst still not strong, is sloping back up and is approaching the 90% retracement level. See ProfitSource chart in Chart 1:

Chart 1

click to enlarge

In this trade, I’m going to buy a December $2.50/$2.75/$3 Call Butterfly. This means that I will buy one contract of the $2.50 Call options, sell two contracts of the $2.75 Call options and buy one contract of the $3.00 Call options to complete the Butterfly spread. If I want to increase the number of contracts that I have, then I have to increase the numbers proportionately. That is, the current contract ratio is 1/2/1, the next ratio would be 2/4/2 and then 4/8/4 - you get the idea. There are many more variations in the Butterfly family, but for now I’ll stay with the basic strategy.

Butterfly spreads don’t normally start making a decent profit until very close to expiration and even then the share has to be trading in the profit zone, as shown in the OptionGear risk graph in Chart 2. These short term trades are designed to take advantage of selling over-priced options at the strike price where you believe the share will be trading at expiration. The idea is that the short options ($2.75) will be basically worthless at expiry and your long option ($2.50) at the lower strike price will be in the money. You are not worried about your long out of the money option ($3.00); it’s just an insurance policy.

The actual order is:

Buy to open 5 x Dec $2.50 Call contracts

Sell to open 10 x Dec $2.75 Call contracts

Buy to open 5 x Dec $3.00 Call contracts

Placed as one order, for a total debit of 50 cents per Butterfly spread, this means that there are 5 spreads x 50 cents x 1000 (shares per contract) equals $250 cost for the whole trade and a maximum profit of $1000.

Chart 2

click to enlarge

With these types of trades you have to close the trade to get your profit. That is, you have to sell your long positions and buy back your shorts. Normally these trades don’t show a profit until very close to expiration.

My trade plan is quite straight forward, hold until 1 or 2 days before expiration and close the trade if any of the legs are in the money, otherwise let it expire worthless. There is no stop loss. I’m prepared to lose the whole $250 entry debit.

Again, this is a simple trading plan and I’m limiting my risk by using a smaller position size rather than using a stop loss.